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Thursday, September 8, 2011

Capital Efficiency

Yadda Yadda Yadda

~ You can't swing a dead cat in a room full of investors these days without whacking at least one person praising the virtues of capital efficiency. Capital efficiency? Say what?

Capital efficiency in the startup investment world refers to a company's ability to make more progress, or advance to stages of lower risk, with fewer investor dollars. It's a laudable objective to be sure; these days who doesn't prize the ability to do more with less? However, the mindless mantra of capital efficiency should merit more scrutiny.

It's swell if you're a software play. Put a couple of wired geeks in a room with a case of Monster, fast rigs and a T-1 and you can birth a beta in mere weeks that will wow the digeratti.

But what if you're a startup in something other than software? Regrettably, you'd be in a position of explaining, not a good place from which to pitch.

At the risk of being a heretic, I'm going to call out the naked emperor: software is boring. And redundant. Too many are piling on with me me-too plays and feckless filigrees on niche plays that mean little. Who cares? There's more to a good investment than a modest need for capital.

There will always be money to be made in truly creative software ideas, for sure. But too many seem derivative, narrow and, well, speculative, to a degree that suggests high investment risk in a crowded space, at least to this recovering software engineer.

Capital efficiency holds out the promise of sweet returns for relatively small capital outlay. But competitors could do the same... Capital efficiency—a smallish capital outlay—means lower barriers to entry for competitors; others could, by definition, produce something similar for not a whole lot.

Enterprises that require more capital, on the other hand are harder for competitors to assail because they would need more capital to do so. Companies in industries that must spend more to get their version 1.0 complete have higher barriers to entry, as competitors must also spend larger to catch up, to compete, to garner attention, to gain credibility.

The term "capital efficiency" is unfortunate, as it suggests that businesses that require more investment are capital inefficient. However, businesses are not inefficient per se; it is not the idea, but the execution: inefficiencies arise not from the business but from the management team, especially if unskilled or inept.

Capital efficient investments are the spun sugar of investment—airy, rush-inducing, and sweet to the first taste. But they don't sustain. They are empty calories, and the sugar-buzz gives way to a precipitous let-down (and a quest for the next fix.) The real meal of a meaty investment takes more preparation, but eschews the ephemeral satisfaction for a repast of real sustenance.

In startup investing, capital efficiency is the flip side to the height of the barrier to entry. With a solid team and a crisp business conception more capital input translates to a more robust and sustainable competitive advantage. Perseveration on capital efficiency. alternatively, bespeaks unease in the business model or the management team.